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Solution Manual for International Economics Theory and Policy, 11th Edition

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    Instructor’s Manual For International Economics: Theory and Policy Eleventh Edition Paul R. Krugman Princeton University Maurice Obstfeld University of California, Berkeley Marc J. Melitz Harvard University Prepared by Hisham Foad San Diego State University

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    Table of Contents Chapter 1 Introduction ............................................................................................................. 1 Chapter 2 World Trade: An Overview ..................................................................................... 3 Chapter 3 Labor Productivity and Comparative Advantage: The Ricardian Model ................ 7 Chapter 4 Specific Factors and Income Distribution ............................................................. 13 Chapter 5 Resources and Trade: The Heckscher-Ohlin Model .............................................. 21 Chapter 6 The Standard Trade Model .................................................................................... 29 Chapter 7 External Economies of Scale and the International Location of Production ......... 37 Chapter 8 Firms in the Global Economy: Export Decisions, Outsourcing, and Multinational Enterprises ............................................................................... 43 Chapter 9 The Instruments of Trade Policy ........................................................................... 51 Chapter 10 The Political Economy of Trade Policy ................................................................. 60 Chapter 11 Trade Policy in Developing Countries .................................................................. 69 Chapter 12 Controversies in Trade Policy ............................................................................... 73 Chapter 13 National Income Accounting and the Balance of Payments .................................. 80 Chapter 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach ............. 89 Chapter 15 Money, Interest Rates, and Exchange Rates ........................................................ 100 Chapter 16 Price Levels and the Exchange Rate in the Long Run ......................................... 110 Chapter 17 Output and the Exchange Rate in the Short Run ................................................. 119 Chapter 18 Fixed Exchange Rates and Foreign Exchange Intervention ................................ 130 Chapter 19 International Monetary Systems: An Historical Overview .................................. 141 Chapter 20 Financial Globalization: Opportunity and Crisis ................................................. 152 Chapter 21 Optimum Currency Areas and the Euro .............................................................. 161 Chapter 22 Developing Countries: Growth, Crisis, and Reform ........................................... 171

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    Chapter 1 Introduction ■ Chapter Organization What Is International Economics About? The Gains from Trade. The Pattern of Trade. How Much Trade? Balance of Payments. Exchange Rate Determination. International Policy Coordination. The International Capital Market. International Economics: Trade and Money ■ Chapter Overview The intent of this chapter is to provide both an overview of the subject matter of international economics and to provide a guide to the organization of the text. It is relatively easy for an instructor to motivate the study of international trade and finance. The front pages of newspapers, the covers of magazines, and the lead reports on television news broadcasts herald the interdependence of the U.S. economy with the rest of the world. This interdependence may also be recognized by students through their purchases of imports of all sorts of goods, their personal observations of the effects of dislocations due to international competition, and their experience through travel abroad. The study of the theory of international economics generates an understanding of many key events that shape our domestic and international environment. In recent history, these events include the causes and

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    2 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition consequences of the large current account deficits of the United States; the dramatic appreciation of the dollar during the first half of the 1980s followed by its rapid depreciation in the second half of the 1980s; the Latin American debt crisis of the 1980s and the Mexican crisis in late 1994; and the increased pressures for industry protection against foreign competition broadly voiced in the late 1980s and more vocally espoused in the first half of the 1990s. The financial crisis that began in East Asia in 1997 and spread to many countries around the globe and the Economic and Monetary Union in Europe highlight the way in which various national economies are linked and how important it is for us to understand these connections. These global linkages have been highlighted yet again with how a bust in the American housing market rapidly spread throughout the world, turning into a global financial crisis through linkages across international capital markets. At the same time, protests at global economic meetings and a rising wave of protectionist rhetoric have highlighted opposition to globalization as exemplified by both Brexit and the recent U.S. presidential campaign. The text material will enable students to understand the economic context in which such events occur. Chapter 1 of the text presents data demonstrating the growth in trade and the increasing importance of international economics. This chapter also highlights and briefly discusses seven themes that arise throughout the book. These themes are (1) the gains from trade, (2) the pattern of trade, (3) protectionism, (4) the balance of payments, (5) exchange rate determination, (6) international policy coordination, and (7) the international capital market. Students will recognize that many of the central policy debates occurring today come under the rubric of one of these themes. Indeed, it is often a fruitful heuristic to use current events to illustrate the force of the key themes and arguments that are presented throughout the text.

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    Chapter 2 World Trade: An Overview ■ Chapter Organization Who Trades with Whom? Size Matters: The Gravity Model. Using the Gravity Model: Looking for Anomalies. Impediments to Trade: Distance, Barriers, and Borders. The Changing Pattern of World Trade. Has the World Gotten Smaller? What Do We Trade? Service Offshoring. Do Old Rules Still Apply? Summary ■ Chapter Overview Before entering into a series of theoretical models that explain why countries trade across borders and the benefits of this trade (Chapters 3 – 12), Chapter 2 considers the pattern of world trade that we observe today. The core idea of the chapter is the empirical model known as the gravity model. The gravity model is based on the observations that (1) countries tend to trade with nearby economies and (2) trade is proportional to country size. The model is called the gravity model, as it is similar in form to the physics equation that describes the pull of one body on another as proportional to their size and distance. The basic form of the gravity equation is T ij = A × Y i × Y j / D ij . The logic supporting this equation is that

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    4 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition large countries have large incomes to spend on imports and produce a large quantity of goods to sell as exports. This means that the larger that either trade partner is, the larger the volume of trade between them. At the same time, the distance between two trade partners can substitute for the transport costs that they face as well as proxy for more intangible aspects of a trading relationship such as the ease of contact for firms. This model can be used to estimate the predicted trade between two countries and look for anomalies in trade patterns. The text shows an example where the gravity model can be used to demonstrate the importance of national borders in determining trade flows. According to many estimates, the border between the United States and Canada has the impact on trade equivalent to roughly 1,500 – 2,500 miles of distance. Other factors such as tariffs, trade agreements, and common language can all affect trade and can be incorporated into the gravity model. The chapter also considers the way trade has evolved over time. Although people often feel that globalization in the modern era is unprecedented, in fact, we are in the midst of the second great wave of globalization. From the end of the 19th century to World War I, the economies of different countries were quite connected, with trade as a share of GDP higher in 1910 than in 1960. Only recently have trade levels surpassed pre – World War I trade. The nature of trade has changed, though. The majority of trade is in manufactured goods with agriculture and mineral products making up less than 20% of world trade. Even developing countries now primarily export manufactures. A century ago, more trade was in primary products as nations tended to trade for things that literally could not be grown or found at home. Today, the motivations for trade are varied, and the products we trade are increasingly diverse. Despite increased complexity in modern international trade, the fundamental principles explaining trade at the dawn of the global era still apply today. The chapter concludes by focusing on one particular expansion of what is “tradable”— the increase in services trade. Modern information technology has expanded greatly what can be traded as the person staffing a call center, doing your accounting, or reading your X-ray can literally be halfway around the world. Although service outsourcing is still relatively rare, the potential for a large increase in service outsourcing is an important part of how trade will evolve in the coming decades. The next few chapters will explain the theory of why nations trade. ■ Answers to Textbook Problems 1. We saw that not only is GDP important in explaining how much two countries trade, but also, distance is crucial. Given its remoteness, Australia faces relatively high costs for transporting imports and exports, thereby reducing the attractiveness of trade. Because Canada has a border with a large

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    Chapter 2 World Trade: An Overview 5 economy (the United States) and Australia is not near any other major economy, it makes sense that Canada would be more open and Australia more self-reliant. 2. Mexico is quite close to the United States, but it is far from the European Union (EU), so it makes sense that it trades largely with the United States. Brazil is far from both, so its trade is split between the two. Mexico trades more than Brazil in part because it is so close to a major economy (the United States) and in part because it is a member of a trade agreement with a large economy (NAFTA). Brazil is farther away from any large economy and is in a trade agreement with relatively small countries. 3. No, if every country’s GDP were to double, world tr ade would not quadruple. Consider a simple example with only two countries: A and B. Let country A have a GDP of $6 trillion and B have a GDP of $4 trillion. Furthermore, the share of world spending on each country’s production is proportional to each coun try’s share of world GDP (stated differently, the exponents on GDP in Equation 2-2, a and b, are both equal to 1). Thus, our example is characterized by the table below: Country GDP Share of World Spending A $6 trillion 60% B $4 trillion 40% Now let us compute world trade flows in this example. Country A has an income of $6 trillion and spends 40% of that income on country B’s production. Thus , exports from country B to country A are equal to $6 trillion × 40% = $2.4 trillion. Country B has an income of $4 trillion and spends 60% of this on country A’s production. Thus, exports from country A to country B are equal to $4 trillion × 60% = $2.4 trillion. Total world trade in this simple model is $2.4 + $2.4 = $4.8 trillion. What happens if we double GDP in both countries? Now GDP in country A is $12 trillion, and GDP in country B is $8 trillion. However, the share of world income (and spending) in each country has not changed. Thus, country A will still spend 40% of its income on country B products, and country B will still spend 60% of its income on country A products. Exports from country B to country A are equal to $12 trillion × 40% = $4.8 trillion. Exports from country A to country B are $8 trillion × 60% = $4.8 trillion. Total trade is now equal to $4.8 + $4.8 = $9.6 trillion. Looking at trade before and after the doubling of GDP, we see that total trade actually doubled, not quadrupled. 4. As the share of world GDP that belongs to East Asian economies grows, then in every trade relationship that involves an East Asian economy, the size of the East Asian economy has grown. This makes the trade relationships with East Asian countries larger over time. The logic is similar to why the countries trade more with one another. Previously, they were quite small economies,

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    6 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition meaning that their markets were too small to import a substantial amount. As they became wealthier and the consumption demands of their populace rose, they were each able to import more. Thus, while they previously had focused their exports to other rich nations, over time they became part of the rich nation club and thus were targets for one another’s exports. Again, using the gravity model, when South Korea and Taiwan were both small, the product of their GDPs was quite small, meaning that despite their proximity, there was little trade between them. Now that they have both grown considerably, their GDPs predict a considerable amount of trade. 5. As the chapter discusses, a century ago much of world trade was in commodities, which were in many ways climate or geography determined. Thus, the United Kingdom imported goods that it could not make itself. This meant importing things like cotton or rubber from countries in the Western Hemisphere or Asia. As the United K ingdom’s climate and natural resource endowments were fairly similar to those of the rest of Europe, it had less of a need to import from other European countries. In the aftermath of the Industrial Revolution, where manufacturing trade accelerated and has continued to expand with improvements in transportation and communications, it is not surprising that the United Kingdom would turn more to the nearby and large economies in Europe for much of its trade. This result is a direct prediction of the gravity model.

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    Chapter 3 Labor Productivity and Comparative Advantage: The Ricardian Model ■ Chapter Organization The Concept of Comparative Advantage. A One-Factor Economy. Relative Prices and Supply. Trade in a One-Factor World. Determining the Relative Price after Trade. Box: Comparative Advantage in Practice: The Case of Babe Ruth. The Gains from Trade. A Note on Relative Wages. Box: The Losses from Nontrade. Misconceptions about Comparative Advantage. Productivity and Competitiveness. Box: Do Wages Reflect Productivity? The Pauper Labor Argument. Exploitation. Comparative Advantage with Many Goods. Setting Up the Model. Relative Wages and Specialization.

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    8 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition Determining the Relative Wage in the Multigood Model. Adding Transport Costs and Nontraded Goods. Empirical Evidence on the Ricardian Model. Summary ■ Chapter Overview The Ricardian model provides an introduction to international trade theory. This most basic model of trade involves two countries, two goods, and one factor of production, labor. Differences in relative labor productivity across countries give rise to international trade. This Ricardian model, simple as it is, generates important insights concerning comparative advantage and the gains from trade. These insights are necessary foundations for the more complex models presented in later chapters. The text exposition begins with the examination of the production possibility frontier and the relative prices of goods for one country. The production possibility frontier is linear because of the assumption of constant returns to scale for labor, the sole factor of production. The opportunity cost of one good in terms of the other equals the price ratio because prices equal costs, costs equal unit labor requirements times wages, and wages are equal in each industry. After defining these concepts for a single country, a second country is introduced that has different relative unit labor requirements. Supply and demand curves relative to general equilibrium are developed. This analysis demonstrates that at least one country will specialize in production. The gains from trade are then demonstrated with a graph and a numerical example. The intuition of indirect production, that is “producing” a good by producing the good for which a country enjoys a comparative advantage and then trading for the other good, is an appealing concept to emphasize when presenting the gains from trade argument. Students are able to apply the Ricardian theory of comparative advantage to analyze three misconceptions about the advantages of free trade. Each of the three “myths” represents a common argument against free trade, and the flaws of each can be demonstrated in the context of examples already developed in the chapter. The first myth is that trade is driven by absolute advantage. This chapter clearly demonstrates that it is comparative advantage that matters. The second is the pauper labor argument, with poor countries having a n “unfair advantage” in trade given low-cost labor. The chapter highlights that the gains from trade are irrelevant to the source of comparative advantage. Finally, the myth of workers in poor countries being exploited by trade is exposed by asking whether these workers would be better off without trade. As the numerical example in this chapter demonstrates, the answer is a resounding “ no. ”

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    Chapter 3 Labor Productivity and Comparative Advantage: The Ricardian Model 9 Although the initial intuitions are developed in the context of a two-good model, it is straightforward to extend the model to describe trade patterns when there are N goods. Comparative advantage in this model is driven by relative wages between countries rather than relative prices. However, the implication that countries will export goods for which they have the lowest opportunity cost remains. The N -good model is used to discuss the role that transport costs play in making some goods nontraded. As transport costs rise, the gains from trade decrease, and in some cases they are completely eliminated. The chapter ends with a discussion of empirical evidence of the Ricardian model. The authors are careful to point out that, while the rather simplified model cannot explain all trade patterns, the basic prediction that countries tend to export goods for which they have a comparative advantage (high relative productivity) has been confirmed by a number of studies. ■ Answers to Textbook Problems 1. a. The production possibility curve is a straight line that intercepts the apple axis at 400 (1,200/3) and the banana axis at 600 (1,200/2). b. The opportunity cost of apples in terms of bananas is 3/2. It takes 3 units of labor to harvest an apple but only 2 units of labor to harvest a banana. If one forgoes harvesting an apple, this frees up 3 units of labor. These 3 units of labor could then be used to harvest 1.5 bananas. c. Labor mobility ensures a common wage in each sector, and competition ensures the price of goods equals their cost of production. Thus, the relative price equals the relative costs, which equals the wage times the unit labor requirement for apples divided by the wage times the unit labor requirement for bananas. Because wages are equal across sectors, the price ratio equals the ratio of the unit labor requirement, which is 3 apples per 2 bananas.

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    10 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition 2. a. The production possibility curve is linear, with the intercept on the apple axis equal to 160 (800/5) and the intercept on the banana axis equal to 800 (800/1). b. The world relative supply curve is constructed by determining the supply of apples relative to the supply of bananas at each relative price. The lowest relative price at which apples are harvested is 3 apples per 2 bananas. The relative supply curve is flat at this price. The maximum number of apples supplied at the price of 3/2 is 400 supplied by Home while, at this price, foreign harvests 800 bananas and no apples, giving a maximum relative supply at this price of 1/2. This relative supply holds for any price between 3/2 and 5. At the price of 5, both countries would harvest apples. The relative supply curve is again flat at 5. Thus, the relative supply curve is step shaped, flat at the price 3/2 from the relative supply of 0 to 1/2, vertical at the relative quantity 1/2 rising from 3/2 to 5, and then flat again from 1/2 to infinity.

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    Chapter 3 Labor Productivity and Comparative Advantage: The Ricardian Model 11 3. a. The relative demand curve includes the points (1/5, 5), (1/2, 2), (2/3, 3/2), (1, 1), (2, 1/2). b. The equilibrium relative price of apples is found at the intersection of the relative demand and relative supply curves. This is the point (1/2, 2), where the relative demand curve intersects the vertical section of the relative supply curve. Thus, the equilibrium relative price is 2. c. Home produces only apples, Foreign produces only bananas, and each country trades some of its product for the product of the other country. d. In the absence of trade, Home could gain 3 bananas by forgoing 2 apples, and Foreign could gain by 1 apple forgoing 5 bananas. Trade allows each country to trade 2 bananas for 1 apple. Home could then gain 4 bananas by forgoing 2 apples, while Foreign could gain 1 apple by forgoing only 2 bananas. Each country is better off with trade. 4. The increase in the number of workers at Home shifts out the relative supply schedule such that the corner points are at (1, 3/2) and (1, 5) instead of (1/2, 3/2) and (1/2, 5). The intersection of the relative demand and relative supply curves is now in the lower horizontal section, at the point (2/3, 3/2). In this case, Foreign still gains from trade, but the opportunity cost of bananas in terms of apples for Home is the same whether or not there is trade, so Home neither gains nor loses from trade. 5. This answer is identical to that in Answer 3. The amount of “effective labor” has not changed because the doubling of the labor force is accompanied by a halving of the productivity of labor. 6. This statement fails to connect wages and productivity. Though wages in China are undoubtedly lower than they are in the United States, the reason for this is that productivity is significantly lower in most industries in China. The diagram in the box titled “Do Wages Reflect Productivity ? ” shows that Chinese productivity is less than 10% that of the United States, corresponding to much lower

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    12 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition wages in China. Thus, even though wages are higher in the United States than they are in China, it is not clear that it is cheaper to produce all goods in China. Given higher productivity, some goods may still be cheaper to produce in the United States, despite higher wages. 7. Wages in China will be determined by productivity in both the manufacturing and the service sectors. Wages are a function of labor productivity and the price of the good or service being traded. That services are generally not traded across borders does influence their price, allowing a different price to be charged in the United States as compared to China, for example. However, the presence of a service sector will still influence wages in both the manufacturing and service sectors. As productivity in the service sector increases, Chinese wages will rise. Wages will also rise as the price received for manufactured goods increases with trade. Thus, wages are a function of productivity and prices in all sectors. 8. One explanation for a lower cost of living in China is that there is high labor productivity in the service sector. This high productivity level will cause the price of services in China to be significantly lower than those in the United States or Europe. Because services are generally nontradable, these price differences can persist even with international trade. If services could be traded, then we would expect the price of services to rise in China and fall in the United States and Europe. However, most services are nontradable and thus living costs in China tend to be lower than in the United States and Europe. 9. As more and more services become tradable, the gains from trade will increase, because the gains from trade increase as the share of nontraded goods decreases. As more and more goods become traded, more opportunities for maximizing comparative advantage through specialization are realized and more countries will be able to focus resources on those industries in which they have the highest productivity. 10. The world relative supply curve in this case consists of a step function, with as many “steps” (horizontal portions) as there are countries with different unit labor requirement ratios. Any countries to the left of the intersection of the relative demand and relative supply curves export the good in which they have a comparative advantage relative to any country to the right of the intersection. If the intersection occurs in a horizontal portion, then the country with that price ratio produces both goods.

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    © 2018Pearson Education, Inc. Chapter 4 Specific Factors and Income Distribution ■ Chapter Organization The Specific Factors Model. Box: What Is a Specific Factor? Assumptions of the Model. Production Possibilities. Prices, Wages, and Labor Allocation. Relative Prices and the Distribution of Income International Trade in the Specific Factors Model. Income Distribution and the Gains from Trade. The Political Economy of Trade: A Preliminary View. Income Distribution and Trade Politics. Case Study: Trade and Unemployment. International Labor Mobility. Case Study: Wage Convergence in the European Union. Case Study: Immigration and the U.S. Economy. Summary APPENDIX TO CHAPTER 4: Further Details on Specific Factors. Marginal and Total Product Relative Prices and the Distribution of Income

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    14 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition ■ Chapter Overview In Chapter 3, the Ricardian model of trade was introduced with labor as the single factor of production exhibiting constant returns to scale. Although informative, this model fails to highlight the observed opposition to free trade. In this chapter, the Specific Factors model is presented to gain a better understanding of the distributional effects of trade. After trade, the exporting industry expands, while the import competing industry shrinks. As a result, the factor specific to the exporting industry gains from trade, while the factor specific to the import competing industry loses from trade. However, the aggregate gains from trade are greater than the losses. The Specific Factors model assumes that there is one factor that is mobile between sectors (commonly thought of as labor) and production factors that are specific to each sector. The chapter begins with a simple economy producing two goods: cloth and food. Cloth is produced using labor and its specific factor, capital. Food is produced using labor and its specific factor, land. Given that capital and labor are specific to their respective industries, the mix of goods produced by a country is determined by share of labor employed in each industry. The key difference between the Ricardian model and the Specific Factors model is that in the latter, there are diminishing returns to labor. For example, production of food will increase as labor is added, but given a fixed amount of land, each additional worker will add less and less to food production. As we assume that labor is perfectly mobile between industries, the wage rate must be identical between industries. With competitive labor markets, the wage must be equal to the price of each good times the marginal product of labor in that sector. We can use the common wage rate to show that the economy will produce a mix of goods such that the relative price of one good in terms of the other is equal to the relative cost of that good in terms of the other. Thus, an increase in the relative price of one good will cause the economy to shift its production toward that good. With international trade, the country will export the good whose relative price is below the world relative price. The world relative price may differ from the domestic price before trade for two reasons. First, as in the Ricardian model, countries differ in their production technologies. Second, countries differ in terms of their endowments of the factors specific to each industry. After trade, the domestic relative price will equal the world relative price. As a result, the relative price in the exporting sector will rise, and the relative price in the import competing sector will fall. This will lead to an expansion in the export sector and a contraction of the import competing sector.

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    Chapter 4 Specific Factors and Income Distribution 15 Suppose that after trade, the relative price of cloth increases by 10%. As a result, the country will increase production of cloth. This will lead to a less than 10% increase in the wage rate because some workers will move from the food to the cloth industry. The real wage paid to workers in terms of cloth ( w / P C ) will fall, while the real wage paid in terms of food ( w / P F ) will rise. The net welfare effect for labor is ambiguous and depends on relative preferences for cloth and food. Owners of capital will unambiguously gain because they pay their workers a lower real wage, while owners of land will unambiguously lose as they now face higher costs. Thus, trade benefits the factor specific to the exporting sector, hurts the factor specific to the import competing sector, and has ambiguous effects on the mobile factor. Despite these asymmetric effects of trade, the overall effect of trade is a net gain. Stated differently, it is theoretically possible to redistribute the gains from trade to those who were hurt by trade and make everyone better off than they were before trade. Given these positive net welfare effects, why is there such opposition to free trade? To answer this question, the chapter looks at the political economy of protectionism. The basic intuition is that the though the total gains exceed the losses from trade, the losses from trade tend to be concentrated, while the gains are diffused. Import tariffs on sugar in the United States are used to illustrate this dynamic. It is estimated that sugar tariffs cost the average person $7 per year. Added up across all people, this is a very large loss from protectionism, but the individual losses are not large enough to induce people to lobby for an end to these tariffs. However, the gains from protectionism are concentrated among a small number of sugar producers, who are able to effectively coordinate and lobby for continued protection. When the losses from trade are concentrated among politically influential groups, import tariffs are likely to be seen. Ohio, a key swing state in U.S. presidential elections and a major producer of both steel and tires, is used as an example to illustrate this point with both Presidents Bush and Obama supporting tariffs on steel and tires, respectively. Although the losers from trade are often able to successfully lobby for protectionism, the chapter highlights three reasons why this is an inefficient method of limiting the losses from trade. First, the actual impact of trade on unemployment is fairly low, with estimates of only 2.5% of unemployment directly attributable to international trade. This fact is highlighted in a case study on the decline in U.S. manufacturing employment, which is often blamed on competition from China. Manufacturing employment had been falling long before the United States had any significant trade with China, suggesting that factors other than trade (at least with China) are responsible. Second, the losses from trade are driven by one industry expanding at the expense of another. This phenomenon is not specific to international trade and is also seen with changing preferences or new technology. Why should policy be

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    16 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition singled out to protect people hurt by trade and not for those hurt by these other trends? Finally, it is more efficient to help those hurt by trade — by redistributing the gains from trade in the form of safety nets for those temporarily unemployed and worker retraining programs to ease the transition from import competing to export sectors — than it is to limit trade to protect existing jobs. Finally, the chapter uses the framework of the Specific Factors model to analyze the distributional effects of international labor migration. With free migration of labor across borders, wages must equalize among countries. Workers will migrate from low-wage countries to high-wage countries. As a result, wages in the low-wage countries will rise, and those in the high-wage countries will fall. Though the net effect of free migration is positive, there will be both winners and losers from migration. Workers who stayed behind in the low-wage country will benefit, as will owners of capital in the high-wage country. Workers in the high-wage country will be hurt, as will owners of capital in the low-wage country. We also need to consider the education levels of migrants relative to the country they move to. Immigrants to the United States, for example, tend to be concentrated in the lowest educational groups. Thus, migration is likely to only have negative effects on the wages of the least educated Americans while raising the wages of those with more education. ■ Answers to Textbook Problems 1. Texas and Louisiana are both oil-producing states. A decrease in the price of oil will reduce output in these two states, hurting owners of capital and workers in the oil industry. Although some capital will be able to migrate to other sectors (for example, those that use oil as a factor of production), a significant fraction of capital is specific to the oil industry. By that same token, some workers in the oil industry have skills that transfer to other sectors, and this transition will take time and is not costless. 2. a.

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    Chapter 4 Specific Factors and Income Distribution 17 b. The curve in the PPF reflects diminishing returns to labor. As production of Q 1 increases, the opportunity cost of producing an additional unit of Q 1 will rise. Basically, as you increase the number of workers producing Q 1 with a fixed supply of capital, each additional worker will contribute less to the production of Q 1 and represents an increasingly large loss of potential production of Q 2 . 3. a. Draw the marginal product of labor times the price for each sector given that the total labor allocated between these sectors must sum to 100. Thus, if there are 10 workers employed in Sector 1, then there are 90 workers employed in Sector 2. If there are 50 workers employed in Sector 1, then there are 50 workers employed in Sector 2. For simplicity, define P 1 = 1 and P 2 = 2 (it does not matter what the actual prices are in determining the allocation of labor, only that the relative price P 2 / P 1 = 2).

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    18 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition In competitive labor markets, the wage is equal to price times the marginal product of labor. With mobile labor between sectors, the wage rate must be equal between sectors. Thus, the equilibrium wage is determined by the intersection of the two P × MPL curves. Looking at the diagram above, it appears that this occurs at a wage rate of 10 and a labor supply of 30 workers in Sector 1 (70 workers in Sector 2). b. From part (a), we know that 30 units of labor are employed in Sector 1 and 70 units of labor are employed in Sector 2. Looking at the table in Question 2, we see that these labor allocations will produce 48.6 units of good 1 and 86.7 units of good 2. At this production point ( Q 1 = 48.6, Q 2 = 86.7), the slope of the PPF must be equal to − P 1 / P 2 , which is − ½. Looking at the PPF in Question 2a, we see that it is roughly equal to − ½. c. If the relative price of good 2 falls to 1.3, we simply need to redraw the P × MPL diagram with P 1 = 1 and P 2 = 1.3. The decrease in the price of good 2 leads to an increase in the share of labor accruing to Sector 1. Now, the two sectors have equal wages ( P × MPL ) when there are 50 workers employed in both sectors. Looking at the table in Question 2, we see that with 50 workers employed in both Sectors 1 and 2, there will be production of Q 1 = 66 and Q 2 = 75.8. The PPF at the production point Q 1 = 66, Q 2 = 75.78 must have a slope of - P 1 / P 2 = − 1/1.3 = − 0.77. d. The decrease in the relative price of good 2 led to an increase in production of good 1 and a decrease in the production of good 2. The expansion of Sector 1 increases the income of the

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    Chapter 4 Specific Factors and Income Distribution 19 factor specific to Sector 1 (capital). The contraction of Sector 2 decreases the income of the factor specific to Sector 2 (land). 4. a. The increase in the capital stock in Home will increase the possible production of good 1, but have no effect on the production of good 2 because good 2 does not use capital in production. As a result, the PPF shifts out to the right, representing the greater quantity of good 1 that Home can now produce. b. Given the increased production possibility for Home, the relative supply of home (defined as Q 1 / Q 2 ) is further to the right than the relative supply for Foreign. As a result, the relative price of good 1 is lower in Home than it is in Foreign. c. If both countries open to trade, Home will export good 1, and Foreign will export good 2. d. Owners of capital in Home and owners of land in Foreign will benefit from trade, while owners of land in Home and owners of capital in Foreign will be hurt. The effects on labor will be ambiguous because the real wage in terms of good 1 will fall (rise) in Home (Foreign) and the real wage in terms of good 2 will rise (fall) in Home (Foreign). The net welfare effect for labor will depend on preferences in each country. For example, if labor in Home consumes relatively more of good 2, they will gain from trade. If labor in Home consumes relatively more of good 1, they will lose from trade. 5. The real wage in Home is 10, while real wage in Foreign is 18. If there is free movement of labor, then workers will migrate from Home to Foreign until the real wage is equal in each country. If 4 workers move from Home to Foreign, then there will be 7 workers employed in each country, earning a real wage of 14 in each country.

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    20 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition We can find total production by adding up the marginal product of each worker. After trade, total production is 20 + 19 + 18 + 17 + 16 + 15 + 14 = 119 in each country for total world production of 238. Before trade, production in Home was 20 + 19 + 18 = 57. Production in Foreign was 20 + 19 + … + 10 = 165. Total world production before trade was 57 + 165 = 222. Thus, trade increased total output by 16. Workers in Home benefit from migration, while workers in Foreign are hurt. Landowners in Home are hurt by migration (their costs rise), while landowners in Foreign benefit. 6. If only 2 workers can move from Home to Foreign, there will be a real wage of 12 in Home and a real wage of 16 in Foreign. a. Workers in Foreign are hurt as their wage falls from 18 to 16. b. Landowners in Foreign benefit as their costs fall by 2 for each worker employed. c. Workers who stay at home benefit as their wage rises from 10 to 12. d. Landowners in Home are hurt as their costs rise by 2 for each worker employed. e. The workers who do move benefit by seeing their wages rise from 10 to 16. 7. By restricting immigration, the drop in wages in the high-wage country is not as high as it would have been had migration been open. By the same token, the increase in wages in the low-wage country is not as large as it would have been with open migration. Thus, migration restrictions increase the net gain from migrating to those lucky few who are able to move.

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    Chapter 5 Resources and Trade: The Heckscher-Ohlin Model ■ Chapter Organization Model of a Two-Factor Economy. Prices and Production. Choosing the Mix of Inputs. Factor Prices and Goods Prices. Resources and Output. Effects of International Trade between Two-Factor Economies. Relative Prices and the Pattern of Trade. Trade and the Distribution of Income. Case Study: North – South Trade and Income Inequality. Skill-Biased Technological Change and Income Inequality. Box: The Declining Labor Share of Income and Capital-Skill Complementarity. Factor-Price Equalization. Empirical Evidence on the Heckscher-Ohlin Model. Trade in Goods as a Substitute for Trade in Factors: Factor Content of Trade. Patterns of Exports between Developed and Developing Countries. Implications of the Tests. Summary APPENDIX TO CHAPTER 5: Factor Prices, Goods Prices, and Production Decisions.

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    22 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition Choice of Technique. Goods Prices and Factor Prices. More on Resources and Output ■ Chapter Overview In Chapter 3, trade between nations was motivated by differences internationally in the relative productivity of workers when producing a range of products. In Chapter 4, the Specific Factors model considered additional factors of production, but only labor was mobile between sectors. In Chapter 5, this analysis goes a step further by introducing the Heckscher-Ohlin theory . The Heckscher-Ohlin theory considers the pattern of production and trade that will arise when countries have different endowments of such factors of production as labor, capital, and land and where these factors are mobile between sectors in the long run. The basic point is that countries tend to export goods that are intensive in the factors with which they are abundantly supplied. Trade has strong effects on the relative earnings of resources and, according to theory, leads to equalization across countries of factor prices. These theoretical results and related empirical findings are presented in this chapter. The chapter begins by developing a general equilibrium model of an economy with two goods that are each produced using two factors according to fixed coefficient production functions. The assumption of fixed coefficient production functions provides an unambiguous ranking of goods in terms of factor intensities. (A more realistic model allowing for substitution between factors of production is presented later in the chapter with the same conclusions.) Two important results are derived using this model. The first is known as the Rybczynski effect . Increasing the relative supply of one factor, holding relative goods prices constant, leads to a biased expansion of production possibilities favoring the relative supply of the good that uses that factor intensively. The second key result is known as the Stolper-Samuelson effect . Increasing the relative price of a good, holding factor supplies constant, increases the return to the factor used intensively in the production of that good by more than the price increase, while lowering the return to the other factor. This result has important income distribution implications. It can be quite instructive to think of the effects of demographic/labor force changes on the supply of different products. For example, how might the pattern of production during the productive years of the “Baby Boom” generation differ from the pattern of production for post– Baby Boom generations? What

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    Chapter 5 Resources and Trade: The Heckscher-Ohlin Model 23 does this imply for returns to factors and relative price behavior? What effect would a more restrictive immigration policy have on the pattern of production and trade for the United States? The central message concerning trade patterns of the Heckscher-Ohlin theory is that countries tend to export goods whose production is intensive in factors with which they are relatively abundantly endowed. Comparing the United States and Mexico, for example, we observe a relative abundance of capital in the United States and a relative abundance of labor in Mexico. Thus, goods that intensively use capital in production should be cheaper to produce in the United States, and those that intensively use labor should be cheaper to produce in Mexico. With trade, the United States should export capital-intensive goods like computers, while Mexico should export labor-intensive goods like textiles. With integrated markets, international trade should lead to a convergence of goods prices. Thus, the prices of capital-intensive goods in the United States and labor-intensive goods in Mexico will rise. According to the Stolper- Samuelson effect , owners of a country’s abundant factors (e.g., capital owners in the United States, labor in Mexico) will gain from trade, while owners of the country’s scarce factors (labor in the United States, capital in Mexico) will lose from trade. The extension of this result is the Factor Price Equalization theorem, which states that trade in goods (and thus price equalization of goods) will lead to an equalization of factor prices. These income distribution effects are more or less permanent, given that factor abundances do not quickly change within a country. Theoretically, the gains from trade could be redistributed such that everyone is better off; however, such a plan is difficult to implement in practice. The political implications of factor price equalization should be interesting to students. After presenting the basic theory behind the Heckscher-Ohlin theory , the rest of the chapter examines empirical tests of the model, beginning with a pair of case studies looking at income inequality in the United States. Wages paid to skilled workers in the United States have been rising at a much faster rate than those paid to unskilled workers over the past few decades. At the same time, there has been a large increase in international trade. Given that the United States is relatively abundant in skilled labor, the Heckscher-Ohlin theory would predict that increased trade should lead to higher wages for skilled workers and lower wages for unskilled workers. On the surface, this appears to be an empirical confirmation of the theory. However, other studies argue that rising wage inequality can only partially be explained by increased trade. According to the Heckscher-Ohlin model, the increase in skilled wages should be driven by an increase in the price of skill-intensive goods following trade. However, skill-intensive goods prices have not increased by nearly the same proportion as skilled wages. If rising wage inequality in a rich country like the United States is driven by factor price equalization, then we should also observe a narrowing gap in developing countries that are exporting low-skill intensive goods. However, income

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    24 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition inequality in these nations is actually larger than in rich countries. Finally, trade between rich and poor nations is simply not large enough to be entirely responsible for the size of the income gap. Rather, the increasing skill premium is most likely due to skill-biased technical innovations like computers that have increased the productivities of skilled workers more than that of unskilled workers. This empirical observation can be modeled by introducing a three-factor production function using unskilled labor, skilled labor, and capital as inputs. Capital acts as a substitute for unskilled labor, but it is a complement to skilled labor. For example, a new machine can replace the work done by an unskilled laborer, but it needs a skilled worker to maintain and design it. With technological change, capital has become more productive and increasingly displaces unskilled workers in both labor abundant developing countries and capital abundant developed countries. This theory can help to explain labor’s decreasing share of total income in both types of countries despite increased trade that would suggest a rising labor share of income in developing countries. Another empirical observation testing the validity of the Heckscher-Ohlin theory is the Leontief paradox . This is the observation that the capital intensity of U.S. exports is actually lower than that of U.S. imports, exactly the opposite of what the theory would predict for a capital abundant country. Further evidence of this paradox is found in global data, with a country’s factor abundance doing a relatively poor job of predicting its trade patterns. Finally, the theory predicts a much larger volume of trade (given observed differences in factor endowments) than we actually see in the data. A country like China, for example, has a significant abundance in labor. However, China’s net exports of labor -intensive goods are lower than what the theory would predict. Similarly, U.S. net imports of labor-intensive goods are lower than what would be expected given its relative labor scarcity. An explanation for this “missing trade” is that the assumption of identical technology across countries is flawed. Rather, there are significant differences in productivity across countries. That said, when the sample is restricted to trade between developed and developing countries (i.e., North – South trade), the Heckscher-Ohlin theory fits well. This is clearly seen in Figure 5-12, with low-skill countries like Bangladesh, Cambodia, and Haiti exporting products that are considerably less skill-intensive than the exports of more developed nations like France, Germany, and the United Kingdom. We can also see this pattern of trade changing as countries develop, as evidenced by the increasing skill intensity of Chinese exports following China’s increased growth and development. These observations have motivated many economists to consider motives for trade between nations that are not exclusively based on differences across countries. These concepts will be explored in later chapters. Despite these shortcomings, important and relevant results concerning income distribution are obtained from the Heckscher-Ohlin theory .

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    Chapter 5 Resources and Trade: The Heckscher-Ohlin Model 25 ■ Answers to Textbook Problems 1. a. The first step is to compute the opportunity costs of both cloth and food. We are given the following resource constraints: a KC = 2 , a LC = 2 , a KF = 3 , a LF = 1 L = 2000; K = 3,000 Each unit of cloth is produced with 2 units of capital and 2 units of labor. Each unit of food is produced with 3 units of capital and 1 unit of labor. Furthermore, the economy is endowed with 2,000 units of labor and 3,000 units of capital. Given these values, we can define the following resource constraints: 2 Q C + Q F ≤ 2000 ➔ Labor constraint 2 Q C + 3 Q F ≤ 3000 ➔ Capital constraint Solve these two constraints for the quantity of food produced: Q F ≤ 2000 − 2 Q C Q F ≤ 1000 − 2/3 Q C This gives us two budget constraints for food production that must both be met. The production possibilities frontier traces out these budget constraints for food and cloth production. Looking at the diagram, we see that production of both food and cloth will take place when the relative price of cloth is between the two opportunity costs of cloth. The opportunity cost of cloth is given by the slopes of the two components of the production possibilities frontier above, 2/3 and 2. When cloth production is low, the economy will be using relatively more labor to produce cloth, and the opportunity cost of cloth is 2/3 a unit of food. However, as cloth production rises, the economy runs scarce on labor and must take capital away from food production, raising the opportunity cost of cloth to 2 units of food. As long as the relative price of cloth lies between 2/3 and 2 units of food, the economy will produce both goods. If the price of cloth falls below 2/3, then the economy should completely specialize in food production (too low a compensation for producing cloth). If the price of cloth rises above 2, complete specialization in cloth will occur (too low a compensation for producing food). b. Note the input requirements for each good. One unit of cloth can be produced using 2 units of capital and 2 units of labor. One unit of food is produced using 3 units of capital and 1 unit of labor. In a competitive market, the unit cost of each good must be equal to the output price.

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    26 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition Q C = 2 K + 2 L ➔ P C = 2 r + 2 w Q F = 3 K + L ➔ P F = 3 r + w This gives us two equations and two unknowns ( r and w ). Solve for the factor prices: w = P F - 3 r P C = 2 r + 2( P F − 3 r ) = 2 r + 2 P F − 6 r = 2 P F − 4 r *** r = (2 P F − P C )/4 *** w = (3 P C − 2 P F )/4 c. Looking at the two expressions in part (b), we see that an increase in the price of cloth will cause the rental rate of capital to fall and the wage rate to laborers to rise. This makes sense, as cloth is a labor-intensive good. An increase in its price will lead to greater production of cloth and an increase in demand for the factor it uses intensively — labor. d. The capital stock increases to 4,000. The labor constraint will remain unchanged, keeping the maximum price of cloth at 2 units of food. The new capital constraint is given by: 2 Q C + 3 Q F ≤ 4,000. Solving for Q F yields: Q F ≤ 1333 − 2/3 Q C . Thus, the minimum price of cloth is also unchanged at 2/3 units of food. The only difference now is that the production possibilities frontier will have a larger horizontal intercept (if cloth is on the horizontal axis). Compared to Figure 5-1, the new production possibilities frontier will intercept the x -axis at 2,000 instead of 1,500. e. The actual production point for cloth and food will depend on the relative prices of cloth and food. If we assume that the economy is producing at a point such that all resources are being utilized (point 3 in Figure 5-1), then we can compute the quantities of cloth and food by setting the resource constraints equal to one another: Q F = 1,333 − 2/3 Q C = 2,000 − 2 Q C . 2 Q C − 2/3 Q C = 2,000 − 1,333. 4/3 Q C = 667. Q C = 500. Q F = 1,333 − 2/3 × 500 = 1,000.

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    Chapter 5 Resources and Trade: The Heckscher-Ohlin Model 27 f. Prior to the expansion of the capital stock, the economy was producing 750 units of cloth and 500 units of food. After the expansion, cloth production fell to 500, while food production increased to 1,000. This is precisely what the Rybczynski effect predicts will happen. 2. The definition of cattle raising as land intensive depends on the ratio of land to labor used in production, not on the ratio of land or labor to output. The ratio of land to labor in cattle exceeds the ratio in wheat in the United States, implying that cattle raising is land intensive in the United States. Cattle raising is land intensive in other countries as well if the ratio of land to labor in cattle production exceeds the ratio in wheat production in that country. Comparisons between another country and the United States are less relevant for this purpose. 3. This question is similar to an issue discussed in Chapter 4. What matters is not the absolute abundance of factors but their relative abundance. Poor countries have an abundance of labor relative to capital when compared to more developed countries. For example, consider a large, rich country like the United States and a small, poor country like Guatemala. Though the United States has more land, natural resources, capital, and labor than Guatemala, what matters for trade is the relative abundance of these factors. The ratio of labor to capital is likely to be much higher in Guatemala than in the United States, reflecting a relative scarcity of capital in Guatemala and abundance in the United States. This makes labor relatively cheaper and capital more expensive in Guatemala than in the United States. Notice that this difference in factor prices is not driven by how much labor Guatemala has compared to the United States, but by the proportion of labor to other factors within each country. 4. In the Ricardian model, labor gains from trade through an increase in its purchasing power. This result does not support labor union demands for limits on imports from less affluent countries. The Heckscher-Ohlin model directly addresses distribution effects by considering how trade impacts the owners of factors of production. In the context of this model, unskilled U.S. labor loses from trade because this group represents the relatively scarce factors in this country. The results from the Heckscher-Ohlin model support labor union demands for import limits. This is a rational policy as labor unions representing unskilled workers are hurt directly by trade that favors the export of skill- intensive goods (and import of low-skill goods). However, the unions may be better served lobbying for resources to increase skill levels among its membership, given that the gains from trade overall will exceed the losses to a particular sector. 5. Specific programmers may face wage cuts due to the competition from India, but this is not inconsistent with skilled labor wages rising. By making programming more efficient in general, this development may have increased wages for others in the software industry or lowered the prices of the goods overall. In the short run, though, it has clearly hurt those with sector-specific skills who

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    28 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition will face transition costs. There are many reasons to not block the imports of computer programming services (or outsourcing of these jobs). First, by allowing programming to be done more cheaply, it expands the production possibilities frontier of the United States, making the entire country better off on average. Necessary redistribution can be done, but we should not stop trade that is making the nation as a whole better off. In addition, no one trade policy action exists in a vacuum, and if the United States blocked the programming imports, it could lead to broader trade restrictions in other countries. 6. The factor proportions theory states that countries export those goods whose production is intensive in factors with which they are abundantly endowed. One would expect the United States, which has a high capital/labor ratio relative to the rest of the world, to export capital-intensive goods if the Heckscher-Ohlin theory holds. Leontief found that the United States exported labor-intensive goods. Bowen, Leamer, and Sveikauskas found, for the world as a whole, the correlation between factor endowment and trade patterns to be tenuous. The data do not support the predictions of the theory that countries’ exports and imports reflect the relative endowments of factors. 7. If the efficiency of the factors of production differs internationally, the lessons of the Heckscher- Ohlin theory would be applied to “effective factors , ” which adjust for the differences in technology or worker skills or land quality (for example). The adjusted model has been found to be more successful than the unadjusted model at explaining the pattern of trade between countries. Factor- price equalization concepts would apply to the effective factors. A worker with more skills or in a country with better technology could be considered to be equal to two workers in another country. Thus, the single person would be two effective units of labor. Thus, the one high-skilled worker could earn twice what lower-skilled workers do, and the price of one effective unit of labor would still be equalized.

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